SEC Rule 15 c 3 5 Risk Management

SEC Rule 15 c 3 -5 Risk Management Controls for Brokers or Dealers with Market Access

BACKGROUND • The SEC finalized Reg. 15 c 3 -5 in November 2010 with a compliance date of July 2011. In June 2011, the compliance date was extended to November 30, 2011 for fixed income securities. • Though often talked about in relation to “naked access” or “sponsored access”, the regulation is much broader.

Who is Covered? • The Regulation applies to every broker-dealer that is an exchange member, an ATS subscriber, or is an ATS operator with non-broker-dealer subscribers. • The rule applies to ALL trades for customers, broker-dealers and any proprietary trades done through an Exchange or ATS. • The rule does not apply to trades done outside of an Exchange or ATS, e. g. , directly between broker-dealers.

Broker-Dealers must: • Establish, document, and maintain a system of risk management controls and supervisory procedures that are reasonably designed to: (1) Systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, and (2) Ensure compliance with all regulatory requirements that are applicable in connection with the market access. • According to the SEC, these systems must be automated and applied pre-trade. • The fundamental idea is that if there automated trading systems, there must be automated controls.

Specifically: The system would be required to: • prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous; • prevent the entry of orders unless there has been compliance with all regulatory requirements that must be satisfied on a pre-order entry basis; and • prevent the entry of orders that the broker-dealer or customer is restricted from trading, • restrict market access technology and systems to authorized persons, • assure appropriate surveillance personnel receive immediate post-trade execution reports

Review • The broker-dealer is required to establish, document, and maintain a system for regularly reviewing the effectiveness of the risk management controls and supervisory procedures and for promptly addressing any issues; • No less frequently than annually, conduct a review of its business activity in connection with market access to assure the overall effectiveness of such risk management controls and supervisory procedures and document that review. • The CEO must annually certify that the risk management controls and supervisory procedures comply with Rule 15 c 3 -5, and that the regular review has been conducted

Bottom Line • If you trade using your MPID on an ATS for your client, you must have established an automated system to stop any trade in excess of credit limits. • If you allow a client to use your MPID to trade on an ATS, this automated system must also apply. • Your firm’s proprietary trades over an ATS are also subject to this rule as if your firm were the client.